In this piece, we will take a look at the top ten long software stock positions among institutional investors according to Jefferies.
After the post-pandemic rush and the subsequent inflation and glut-driven crash experienced by technology stocks, the sector is now fully bathing in the tailwinds and headwinds generated by artificial intelligence. Yet, unlike the pandemic, inflation, and interest rate-driven effects, AI has grown the addressable market for technology companies and shaken up several of them as well.
Within technology, one sector that has been shaken by AI is the software industry. Before AI, software firms were content with generating stable subscription-driven recurring revenue, but with AI, investors are not only focused on their ability to deliver AI products and monetize them but also on the fact that the firms themselves might be made redundant because of the new technology.
Nowhere else is the latter effect clearer than on software as a service (SaaS) stocks. These stocks offer software products on a subscription basis, and their narrative is based on their ability to deliver technologically complex products that businesses are unwilling to develop because of costs. The impact that AI has made on the SaaS sector is driven by the opinion that as AI enables users to easily create their software, several SaaS companies might not be needed in the business world.
To understand how AI has impacted software stocks, consider data from hedge fund Coatue Management. It shows that booming AI interest has led to software stocks taking the back seat as semiconductor stocks bask in investor attention. During the SaaS peak of 2022, the difference between the returns offered by a SaaS stock index and the semiconductor index were at their highest for the past decade. But, as of June 2024, the difference between the semi and the SaaS index is at the highest for the past decade in a 180-degree paradigm shift driven by AI.
These returns have also been driven by the beefy margins delivered by the semiconductor firms. Margins are a key valuation driver of SaaS stocks, and one popular valuation tool among investors is the Rule of 40. This rule sums up a SaaS stock’s revenue growth rate and profit or operating margin and checks whether the new value is greater than 40. As a result, margins play a key role in SaaS valuation, as a 40% or higher margin means that the firm can get away with little to no growth.
Why is 40% important? Well, according to Coatue, as of June 2024, Wall Street’s top AI GPU stock pick and the stock that ranked 6th in our list of the 10 Most Profitable Stocks of the Last 10 Years had operating margins of 65% and 49%, respectively. On the flip side, the largest software company in the world known for its Windows operating system had a margin of 44%. For chip stocks, new products drive margins since they can charge a premium through high prices. Whether these margins are sustained is another matter, and it was also part of the reason that the GPU firms’ shares fell by 6% as its full-year margin gross guidance of mid-70 % fell short of analyst expectations of 76.4%.
Coming back to software stocks, another metric used in their valuation is the price-to-sales ratio since several software and SaaS firms are unprofitable. In the era of AI, the SaaS index quoted by Coatue is trading at 5.5x price to forward sales. This is well below the long-term median of 7.2x and just a quarter of the 2021 peak of roughly 22x. This valuation compression is accompanied by lower revenue growth estimates. As mentioned above, growth is a fundamental tenet of SaaS and software valuation, and as of June 2024, just one percent of software companies had a next twelve-month revenue growth rate greater than 30%. At the peak of the software boom, 30% of firms faced similar expectations. Digging deeper, several factors are driving this trend.
AI is affecting SaaS stocks by making them shift to a consumption-driven model that charges customers for the services used instead of seat-based packages that simply sell capacity. Additionally, software stocks are also reckoning with the fact that their customers might end up using AI to cost-effectively develop their software instead of relying on expensive third-party options. As Jensen Huang shared in a 2021 interview with Time Magazine, well before his firm’s stock posted 1,100% in share price gains:
“AI is a watershed moment for the world. Humans’ fundamental technology is intelligence. We’re in the process of automating intelligence so that we can augment ours. The thing that’s really cool is that AI is software that writes itself, and it writes software that no humans can. It’s incredibly complex. And we can automate intelligence to operate at the speed of light, and because of computers, we can automate intelligence and scale it out globally instantaneously. Every single one of the large industries will be revolutionized because of it. When you talk about the smartphone, it completely revolutionized the phone industry. We’re about to see the same thing happen to agriculture, to food production, to health care, to manufacturing, to logistics, to customer care, to transportation. These industries that I just mentioned are so complex that no humans could write the software to improve it. But finally we have this piece of this new technology called artificial intelligence that can write that complex software so that we can automate it. The whole goal of writing software is to automate something. We’re in this new world where, over the next 10 years, we’re going to see the automation of automation.”
So, as the software industry undergoes a once-in-a-generation shift, it’s important to see how institutional investors are positioning their trades. Its latest survey is historic as it shows that just 19% of institutional investors are overweight in software stocks, the lowest reading recorded since the survey started. The figure sat at 51% in January and dropped to 28% in July. Yet, even though investors are less overweight, they’ve also reduced their short exposure as they’ve shorted 54 software stocks as of October 11th – down from 73 in July. So, let’s take a look at the stocks that they persist to be long in.
A data analyst in a lab monitoring a cloud-based software system to detect cardiac disease.
Our Methodology
To make our list of Jefferies’ top overcrowded software long positions, we ranked the top ten crowded long positions from the latest Trading Positioning Survey by their shares short as a percentage of outstanding shares.
For these stocks, we also mentioned the number of hedge fund investors. Why are we interested in the stocks that hedge funds pile into? The reason is simple: our research has shown that we can outperform the market by imitating the top stock picks of the best hedge funds. Our quarterly newsletter’s strategy selects 14 small-cap and large-cap stocks every quarter and has returned 275% since May 2014, beating its benchmark by 150 percentage points. (see more details here).
10. Palantir Technologies Inc. (NYSE:PLTR)
Number of Hedge Fund Holders In Q2 2024: 44
Shares Short % Of Outstanding: 4.36%
Palantir Technologies Inc. (NYSE:PLTR) is a software company that enables customers to analyze and generate insights from their data. It is one of the most well-known government contractors for intelligence-driven data analysis, and the firm also enables customers to consolidate their data under a single software roof and virtually deploy software. Palantir Technologies Inc. (NYSE:PLTR) stands out from most other software companies through the fact that it works directly with its customers to deploy software. This means that businesses interested in customized products are drawn to the company. These strengths are also manifesting in Palantir Technologies Inc.’s (NYSE:PLTR) income statement. Its US commercial revenue grew by 70% in the second quarter, and the software company also added 96 contracts worth more than $1 million each and 27 contracts worth more than $10 million each. Such deals are the gold standard in the software industry as they help beef up margins and ensure sizeable annual recurring revenue.
Scout Investments mentioned Palantir Technologies Inc. (NYSE:PLTR) in its Q1 2024 investor letter. Here is what the fund said:
“The top contributor to return for the quarter was Palantir Technologies. Sentiment improved on Palantir after it reported stronger than expected commercial customer revenue and free cash flow. U.S. commercial growth was especially encouraging, as U.S. commercial revenue was up by a large percentage year over year for the fourth quarter and U.S. commercial customer count grew nearly as much. We expect Palantir to become one of the premier artificial intelligence (AI) software providers, built on its Foundry and AIP platforms.”
9. CrowdStrike Holdings, Inc. (NASDAQ:CRWD)
Number of Hedge Fund Holders In Q2 2024: 69
Shares Short % Of Outstanding: 4.12%
CrowdStrike Holdings, Inc. (NASDAQ:CRWD) is a cybersecurity software products provider that made headlines earlier this year due to a faulty software update that caused one of the biggest software outages in history. The outage affected an unbelievable 8.5 million computers worldwide, and it is now shaping CrowdStrike Holdings, Inc. (NASDAQ:CRWD)’s narrative as well. While the shares are up by 42% since the post-outage bottom, compared to the pre-outage peak, they are still down 20.8%. Investors are waiting to see whether the reputational impacts from the outage might lead businesses to not renew their contracts with CrowdStrike Holdings, Inc. (NASDAQ:CRWD)’s Falcon system. As for the firm, it is still targeting $10 billion in annual recurring revenue by its fiscal year 2031 and a midpoint free cash flow margin of 36%. Consequently, investors will be combing CrowdStrike Holdings, Inc. (NASDAQ:CRWD)’s upcoming earnings with a fine-toothed comb to see if customer sentiment has weakened to make meeting these guidelines difficult.
Baron Funds mentioned CrowdStrike Holdings, Inc. (NASDAQ:CRWD) in its Q2 2024 investor letter. Here is what the fund said:
“CrowdStrike Holdings, Inc. is a cloud-architected SaaS cybersecurity vendor offering endpoint security, threat intelligence, and cyberattack response services. Shares continued their strong performance from the first quarter and were again a top contributor, rising 19.5% in the second quarter on better execution than peers in the broader security space. The company reported strong quarterly results with 33% year-over-year revenue growth, driven by customers consolidating their cybersecurity spend on CrowdStrike with free cash flow margins reaching 35%. With accelerating market share gains in its core endpoint detection and response offering, emerging products including Cloud, Identity, and SIEM reaching material scale, and newer products in data protection and AI ramping quickly, net new annual recurring revenue and total revenue look to sustain a long duration of growth. With its leading competitive positioning in cybersecurity, the growing threat landscape (which is also driven by the advancements in AI, making hackers more dangerous), its unique lightweight, single-agent, architecture, and its platform approach, we retain conviction in CrowdStrike, which is emerging as the security platform to beat in terms of scale, profitability, and free cash flow conversion.”
